The Journal of Applied Business Research – January/February 2013 Volume 29, Number 1 Material Internal Control Weaknesses And Earnings Management In The Post-SOX Environment Benjamin P. Foster, PhD, CPA, CMA, University of Louisville, USA Trimbak Shastri, PhD, CA, CMA, CIA, University of Louisville, USA ABSTRACT Prior studies found that companies with internal control deficiencies incorporate abnormal accounting accruals into their financial statements. However, these studies did not consider the materiality of abnormal accruals. Abnormal accruals should be within materiality when financial statements receive clean audit opinions. When material internal control weaknesses (MICW) exist, to compensate for additional risk, auditors should apply more audit effort to gain the quantity and quality of evidence necessary to obtain a reasonable degree of assurance to support their audit reports. We find evidence of this because audit fees are significantly higher for MICW companies than those for effective internal controls (EIC) companies in our sample. Accordingly, financial statements receiving clean audit opinions should not contain material abnormal accruals irrespective of whether controls are effective EIC or ineffective MICW. To examine this issue, we use post-SOX data to estimate abnormal accruals using a revenue-based accrual model for a matched sample of companies with clean audit opinions on their financial statements: one-half EIC and the other half with MICW. Then, we establish material abnormal revenue accruals (MARA), which is the difference between estimated abnormal revenue accruals and a quantitative materiality based on assets. Finally, we compare MARA between EIC and MICW companies. We find no significant difference in MARA between EIC and MICW companies. We provide a summary of important findings in Table 3, and conclude with suggestions to further improve audit and financial reporting quality. Keywords: Material Internal Control Weakness; Earnings Management; Internal Control Deficiencies I. INTRODUCTION any papers have been written regarding earnings management, which involves management’s intervention to misstate reported earnings through various means for gainful purpose. Some recent M academic studies indicate that companies with internal control deficiencies are likely to incorporate abnormal accounting accruals into their financial statements (Ashbaugh-Skaife et al., 2008; and Doyle.et al., 2007). Former SEC Chairman, Arthur Levitt, Jr., indicated (JofA 1998) various approaches are used by enterprises to misstate earnings, including: abuse of materiality, accelerating revenue recognition, use of “cookie-jar reserves”, and “big bath charges”. The purpose of this study is to test, for companies that receive unqualified (clean) audit opinions on their financial statements, whether earnings management after the adoption of PCAOB standards is more prevalent in companies with material internal control weaknesses (MICW) than in companies that have effective internal controls (EIC). For this test, we examined financial data and audit fees of a sample of public companies. According to a 2002-GAO report on Financial Statement Restatement, 20 percent of SEC’s enforcement cases in the late 1990s to early 2000s were for violations resulting from financial reporting and accounting practices (GAO 2002). Further, other matters that enabled management to manage earnings included, for example, difficult to implement accounting standards (e.g., accounting for fair values), compensation schemes, and auditors yielding to © 2013 The Clute Institute http://www.cluteinstitute.com/ 183 The Journal of Applied Business Research – January/February 2013 Volume 29, Number 1 management pressures. Ineffective internal controls (together with aggressive accounting practices by management) might facilitate misappropriation of assets and misleading or fraudulent financial reporting, (such as that at WorldCom and Enron). To strengthen the effectiveness of internal controls (and other corporate governance related matters), the Sarbanes-Oxley Act (SOX) was enacted in 2002. The SOX Act established the Public Company Accounting Oversight Board (PCAOB) to monitor the accounting industry to protect the interests of investors in public companies. In this regard, the PCAOB has issued several auditing Standards (AS1-AS15), and adopted some of the AICPA’s auditing standards as interim standards. Specifically, Section 404 of the SOX Act requires the annual report of a public company to include management’s assessment of the effectiveness of internal control over financial reporting (ICFR). PCAOB AS2, which came into effect in 2004, requires auditors to integrate an audit of financial statements with the audit of ICFR, and attest to and report on the assessment made by company management. For 2004 fiscal year ends, over 2,500 public companies reported according to AS2. Of the reporting companies, approximately 15% reported one or more material internal control weaknesses that resulted in auditors issuing adverse opinions on ICFR (Foster et al., 2007). In 2007, PCAOB replaced AS2 with AS5 (which became effective for fiscal years ending on or after November 15, 2007) to make compliance with standards more efficient, e.g., by recommending a top-down approach to audit internal control (IC), amending definitions of material IC weaknesses, and not requiring auditors to report on management’s assessment of internal control. This study examines financial reports from 2009, well after adoption of the SOX Act and PCAOB auditing standards, to provide insight into recent earnings management related actions, and whether the quality of financial reporting can be enhanced. As expected, our analyses revealed that auditors expended more effort examining MICW companies than EIC companies; MICW companies with positive (income increasing) material abnormal accruals (MARA) were subjected to the highest level of audit scrutiny. We also found that companies with EIC exhibit as much or more MARA as those with MICW. (Other contributions to our understanding of auditing and accruals for MICW and EIC companies are included in Table 3.) We also recommend reporting changes to make the financial reporting process relatively more transparent. The remainder of the paper is organized as follows. Section II describes the role of audits in limiting earnings management and presents research questions. Section III describes the approach used to address research questions, data analyses and results. Concluding comments with suggestions to improve quality of audits and financial reporting are presented in Section IV. II. ACCRUAL ACCOUNTING & EARNINGS MANAGEMENT Management is responsible for implementing effective internal control over financial reporting. In addition, to improve the quality of accounting information for reporting, company managers frequently take steps to strengthen other governance related matters. For example, studies indicate that engaging experienced auditors for audits (Mansi et al., 2004; Myers et al., 2003) and appointing former audit partners to audit committees is likely to enhance the quality of financial reporting (Naiker and Sharma 2009). Generating good quality accounting information requires the joint efforts of management, the audit committee, and auditors. Audits as a Deterrent to Earnings Management Irrespective of internal control effectiveness, financial statements audited in accordance with PCAOB standards and receiving a clean audit opinion should contain accounting accruals within the bounds of GAAP and be free of material misstatements. However, in the pre-PCAOB environment, auditors appear to have failed to follow prescribed standards in many audits. For example, the 2002-GAO’s report (referred above) indicated that from January 2001, to February 2002, about 25% of accounting-related cases brought by the SEC involved accounting firms and certified public accountants (CPAs). Auditors follow several steps to effectively plan and execute an integrated audit. One step requires evaluation of the effectiveness of internal control over financial reporting according to PCAOB AS5 to determine appropriate audit procedures. If controls are weak, auditors likely perform a more extensive audit by appropriately varying the nature, timing, and extent of audit procedures (and consequently charge higher audit fees) than when 184 http://www.cluteinstitute.com/ © 2013 The Clute Institute The Journal of Applied Business Research – January/February 2013 Volume 29, Number 1 internal controls are strong. Collectively, internal controls and audit procedures act as screens/filters to prevent, detect and appropriately rectify material misstatements, if any, to ensure that financial statements conform to GAAP (see figure/exhibit). Accrual-accounting, which includes estimates and allocations, by its very nature is likely to allow swings (back and forth) in earnings that are not planned by management and are acceptable to auditors, within certain bounds of materiality. Effective audits are likely to identify/prevent management from incorporating abnormal- accruals that exceed materiality into the financial statements. A previous study found that audits did limit earnings management and that most earnings management occurred within the boundaries of GAAP (Butler et al. 2004). Consequently, a reasonable question is whether the SOX Act and PCAOB oversight limited earnings management through accounting accruals manipulation by public companies receiving clean audit opinions,